Too-Small-To-Survive: The need for further economic integration

Posted
by on 20 April 2012

There has been much talk about the Too-big-to-fail issue of commercial banks after the global financial and economic crisis. Systemic relevant banks could not go bankrupt because of the severe systemic consequences for the whole global economy. The default of Lehmann Brothers has become the example why large banks need a guarantee that they would be saved in case of a major financial market crisis. As a consequence a list of SiFi-Banks[1] was agreed upon by the G20-countries. However, this created a moral hazard problem. Banks with SiFi-status could now rely on a bail-out in case they run into trouble and facing the risk of default. Market discipline is substituted by sovereign guarantees. Lots of countries with oversized financial markets had to pay dearly for such a bail-out.

Iceland

The first victim was Iceland.[2] Icelandic commercial banks started to run global financial market operations ignoring the potential default risk and the impossibility of such a small economy to bail-out their commercial banks in time of crisis. In particular running huge financial operations in foreign currencies made it impossible for the Icelandic central bank to act as lender of last resort. It illustrated to the global community the vulnerability of a small economy with an oversized banking industry. Their banks were too-big-to-fail, but the home country is too-small-to-survive. Without external support the Icelandic economy was doomed to default.

Ireland

The evil twins of a small economy with an oversized financial sector repeated again in the case of Ireland. Ireland a once fairly backward economy started its rise by operating an on-shore industry in particular of foreign multinational countries seeking access to the European common market. Furthermore Ireland as well became an on-shore weakly regulated financial center in the Euro-zone. Again this became a fatal risk when the global financial market crisis spilled-over to the Euro-zone countries. Since the Maastricht Treaty explicitly in article 95 ruled out a bail-out of any member country in case of crisis the Irish government hastily tried to bail-out their distressed financial sector running instantly a bizarre public deficit of more than 34 percent in 2009. Ireland would have defaulted immediately after that without external help from the other Euro-zone countries.[3] Again the principle of a too-big-to-fail commercial sector combined with the too-small-to-survive country size was illustrated. It could happen again at an even bigger size.

The UK

The UK followed its ambition to become with London City the global top player in the financial sector industry. However, this poses severe challenges to the British economy. Staying outside the Euro-zone it faces the same fundamental weakness like Iceland. In case of the outbreak of another global financial market crisis the Bank of England would be inept to bail-out their commercial banks. Even if Britain managed to stay out of the focus of the global financial market investors as a potential crisis spot, the financial fragility of Britain prevails. May be that the global financial market investors of hedge funds, private equity or conduits of international investment banks shy away to test the capability of the British government to bail-out the system, not at least because they have their residence in the London city, this might change when creditors from the BRICS-countries much less dependent would become skeptical about the stability of the British financial system.

Switzerland

A similar risk is facing Switzerland who as well lived for quite some time well as a global financial center and safe haven for foreign capital which attempted to avoid taxation at home or even had an ambiguous background and were looking for opportunities of money laundering. Again Switzerland with its own currency but commercial banks operating globally in foreign currencies would face immediate default in case of a major crisis of confidence in the Swiss financial sector. Even such a rich country like Switzerland could not bail-out their financial sector in case of a major systemic crisis. It is no accident that the Swiss government enacted much more restrictive regulations of their commercial banks than were agreed upon internationally in the Basel III-agreement. The Swiss know all too well that they should never become a target of global speculators that their banks are overexposed to international financial market risk and would need a bail-out.[4] The Swiss economy is already suffering from the global safe haven status which drives up the Swiss Franc opposite the other currencies in particular the Euro. This forces the Swiss National Bank to intervene at the currency market to keep the Swiss Franc exchange rate below the threshold level of 1.20 exchange rates opposite the Euro. Otherwise the real economy of Switzerland would begin to fall into deep recession because it is heavily export oriented.

What’s the lesson to be learned?

A small country cannot attempt to stay a global financial market player with a commercial banking sector including bank too-big-to-fail banks. It cannot overcome the intrinsic vulnerability of the too-small-to-survive in the case of a global systemic financial market crisis. Therefore there are two alternative ways out of the problem.

First shrink the national commercial banking sector to get rid of the SiFi-banks or integrate with other countries to reach a size to survive such a major systemic financial market crash. At the moment it seems that those countries in danger try to avoid such major institutional reforms. They live on the illusion that such a day of reckoning may never happen soon so that this vulnerability will never be tested. But this failure to rapidly establish new safe global financial market architectures may make such an event much more likely to occur soon as is currently believed.

It could become a traumatic awakening when the Minsky moment[5] strikes again. Greater economic integration would become a necessity and not an option any more. Otherwise the global financial market integration would rapidly disintegrate. The time for free riders in an instable global financial market economy is running out.